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Did Wall St. Bonuses Cause the Financial Crisis?

The journalistic accounts of events at Lehman and Bear report executives holding this belief.

Under this view, the losses at Bear and Lehman were caused not just by ignorance of the riskiness of the mortgage-related securities, but by ignorance of the pain financial regulators were willing to inflict on failed financial firms. Cayne and Fuld were not only mistaken about mortgage risk -- they were mistaken about the strength of government support for their firms.

The best solution to this would be to remove the ability of government to bail out financial firms. Indeed, the Dodd-Frank financial reforms attempt to do this. Unfortunately, this scheme is not credible. It is riddled with holes that would allow regulators to provide a bailout for the health of the financial system.

"The promise of 'no more bailouts,' enshrined in last year's Wall Street reform law, is just that -- a promise. The financiers (and their lawyers) will always stay one step ahead of the regulators. No one really knows what will happen the next time a giant bank goes bust because of its misunderstanding of risk," Taleb explains.

Similarly, greater supervisory regulation is unlikely to help.

Regulators are hopelessly outmatched. And, in any case, the problem of mistakes about risk, about unpredictable events, will always overwhelm the ability of regulators to prevent failure.

Taleb's answer is to end bonuses at firms large or important enough to endanger the general public. He thinks that without the incentive of bonuses, the banks would take on far less risk.

I'm not sure this is right. There's a lot of evidence that shareholders themselves want more risk, and will punish executives who decline to take on more risk. Listen to any call between bank executives and analysts and you will hear the call for putting more money to work, code for taking on more risk. Shareholders do not say they want more risk -- they say they want higher returns. But it comes to the same thing.

Shareholders, after all, have the same incentives as Cayne and Fuld.

And the same blind spots about failure. The downside is limited to the loss of the value of the shares plus the value of a potential bailout.

So I'm not sure that ending bonuses would limit risk-taking or prevent catastrophic failure.

If it's Black Swans and bailouts all the way down, there may not be any solution short of actually breaking up banks or making it too costly -- through extremely high capital requirements -- to run a firm too big to fail.

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Written by John Carney, CNBC.com Senior Editor

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